To track the intended -- and more importantly, unintended -- consequences of policies,market movements,buyout deals and regulatory censure. This forum will map the multiplier effect of what may seem minor events initially but spread out far and wide.

12/08/2010

Tale of two companies: part 2: Minting money off the Meltdown

This is the second part in the series profiling a small Wall Street firm that profited from the carnage of the 2008 financial meltdown. As the biggest financial institutions imploded, this tiny start-up bloomed...read on:

By August, 2007, two hedge funds of the fifth-largest investment bank Bear Stearns had melted as news spread that their bets on mortgage-backed securities went awry and French bank BNP Paribus suspended investor withdrawals from three funds saying it couldn't value their assets anymore -- setting off what many experts say the beginning of the most financial meltdown since the Great Depression.

This story, however, is not about those got decimated. Tucked away on the 12th floor of an imposing building on 26 Broadway in downtown New York, a small firm then called ‘Restricted Stock Partners’, with just $2.5 million in profits, had begun to smell blood.

By end of 2008, Bear Stearns had been sold to J.P.Morgan for a paltry $2 per share; mortgage giants Freddie Mac and Fannie Mae had imploded; Lehmann Brothers had filed for bankruptcy; AIG was nationalized as were the Big three – Ford Motors, General Motors and Chrysler – of the auto sector and a $787 billion stimulus package had been prepared to kickstart the economy.

That year, our small firm, now rechristened as ‘Second Market’ made a ten-fold increase in profits to $20 million, expanded its employee base, added new categories of business and was struggling to keep pace with a spectacular surge in business. In 2008 and much of 2009 as the US economy was haemorrhaging, this tiny firm’s profits swelled to $35 million.

So what business was it that nourished Second Market even as others crumbled around it?

Founded in 2004 by entrepreneur Garry Silbert and born-again in the 2008 financial crisis, Second Market has created an online trading platform for buying and selling the most toxic and illiquid of assets that many financial institutions were choking on two years back.

An e-bay kind auction format, this has created markets for categories such as asset-backed securities, mortgage-backed securities, bankruptcy claims and collateralized debt obligations – categories that fund managers didn’t want to touch with a barge-pole after the housing bubble burst.

So are they traders of misfortune? “We are just a market maker. We provide liquidity to assets that would otherwise be stuck on firms’ balance sheets for years,” said Second Market’s head of public affairs Mark Murphy. “We give these investors an exit route.”

The firm claims that it brings transparency to these opaque assets on sale by specifying about what’s inside these asset-backed securities -- information that is vetted by its legal department. “People can decide what level of risk they want to buy into. Earlier, they didn’t know, not even the cleverest of bankers who designed them, what was inside these securities,” said Murphy. referring to all the multiple layers of leveraging that had created so many derivatives that it was hard to know what could lay claim on which physical asset at what value anymore.

In April 2009, it launched a market for trading stock of private companies – a division that will clearly emerge as Second Market’s cash cow in the coming years. Transactions on its hottest private stock, Facebook peg its valuation at $30 billion, topping the market capitalization of the publicly-listed internet giant Yahoo. Trading on the social network firm has already gone past $150 million with an average transaction size of $2 million.

The working is simple: sellers list their wares and buyers go shopping for the deals. Sometimes, buyers list what they are looking for and sellers emerge. Private company stock is usually sold by either big private equity investors or employees who want out. Second Market makes a cut on every transaction – there is no subscription fee but the spread varies from a few basis points to 4-5% in case of private company stock.

The sellers could be any bank, financial institution or pension fund that is stuck with a white elephant asset – too hard to sell, too costly to keep but was once deemed valuable – while the buyers are usually vulture funds and hedge funds which are looking for rich pickings at a huge discount. Sellers either put a stagnant price, a la Craigslist, follow a Dutch auction model where prices are marked down until a buyer emerges.

The firm is regulated by Financial Industry Regulatory Authority and Securities Markets Commission.

In 2000, the average incubation timeline from a start-up to public listing was 4.5-5 years. As investors took flight and the IPO market dehydrated post 2008, it has increased to 10-11 years, explains Murphy. People need to cash out sooner than that. Moreover, if promoters like Facebook’s Mark Zuckerberg are dragging their feet over going public, likelihood of smaller, weaker firms going out is even smaller.

Besides, such private exchange trade helps in price discovery – a sort of book building process – in the pre-IPO stage, gives a valuation benchmark for mergers and PE deals and helps in branding. Second Market also allows companies to exercise significant control over how often their shares will be traded, what disclosures will accompany and if they want to keep certain activist shareholders out, by using their ‘right of first refusal’.

Second Market’s counter-cyclical business model -- Murphy disagrees with the description -- will keep getting traction as long as the economy crawls to a slow recovery. US is expected to turn in 2.1% growth over the next 2-3 years even its banks fail in record numbers and unemployment is at 9.6%.

Second Market this year will likely continue its rally. It had about 23,000 market participants in October up from 6,500 in January this year. In 2005, they had merely 2,500 when Murphy says they "were hustling to get deals." Now they have to hustle their IT and legal departments to keep up with the swelling business.

Bring nimble-footed has served the firm well. In February 2008, $330 billion worth of ‘auction rate securities’ market went illiquid in a matter of days as banks shuttered desks. The e-trading platform firm leapt on the opportunity and created a market – tiding over financial, technological and legal issues – within 10 days. Since then, every few months it has launched new markets and is now considering launching trading in 363 bankruptcy sales, condo-hotels, private REITS and Trust Preferred Securities.

But how will the firm run when the economy runs out of toxic assets?

Murphy disagrees that his firm’s business is “counter-cyclical” and said that even when tap runs dry on toxic assets, private firm stocks will be the main revenue earner especially as they expand to Asian markets of Singapore and Hong Kong.

Counter-party risk, or the risk of someone reneging on a trade, is another aspect but Murphy says that has never happened in any of their transactions so far.

Another pitfall is that it could be harder to keep employees motivated to stick around if they can cash out early. These are all problems companies usually faced when they went public. Now they will face them earlier.

Until any of these problems hit home, Second Market, often counted among the hottest start-ups in US, is on a trot. It has devised and trademarked their ‘Manhattan auction model’ under which the seller sets aside a portion of the sale proceeds, called participation award, that is distributed say the top three or five bidders after the transaction settles. This incentivizes investors to look at illiquid assets and submit an informed bid.

So will Second Market ever list on Second Market? “In this new year, in 2011, we will allow trading in our shares on our website and let the employees cash out,” said Murphy. More importantly, it'll value a company whose business model has no precedent at all...

Comments

Thanks for writing in! Watch out for this firm as it navigates muddy regulatory waters, if this stuff interests you...SecondMarket was under SEC scanner -- may be still is -- for its private trading of Facebook shares and the resultant shareowner base..